Reading: Determinants of Market Interest Rates
Determinants
of Interest Rates
r = r* + IP + DRP + LP + MRP
•r =
required rate of return
•r*
= real risk free rate of interest
•IP
= inflation premium
•DRP
= default risk premium
•LP
= liquidity risk premium
•MRP
= maturity risk premium
•The
required rate of return (RRR) is the minimum annual percentage earned by an
investment that will induce individuals or companies to put money into a
particular security or project. The RRR is used in both equity valuation and in
corporate finance. Investors use the RRR to decide where to put their money,
and corporations use the RRR to decide if they should pursue a new project or
business expansion.
•Using
the RRR, investors compare the return of an investment to all other available
options, taking into consideration the risk-free rate of return, inflation and
liquidity. Corporations
also
use RRR to calculate net present value in discounted cash flow analysis.
i =
inflation premium
•The
primary market force causing an inflation premium is an expectation of
inflation. When inflation is significant (as it has been to varying degrees
since World War II), lenders know the money they will be repaid will be lower
in value. They raise interest rates to compensate for the expected loss. A
contributing factor is that borrowers, believing prices will rise, are more
willing to pay higher interest rates to purchase goods and services on credit
sooner, rather than later, when they believe prices will be higher.
•Interest
rates have three components. The first is the risk-free return. This is the
amount of interest that lenders charge for the use of their money if there is
no risk of not being repaid. The inflation premium is added to the risk-free
rate to offset expected losses from the declining value of money due to
inflation. The third component is the amount lenders charge to offset credit
risks.
•It’s
impossible to precisely calculate the inflation premium, since it depends on
expectations about the future. However, it’s fairly simple to estimate the
inflation premium. Typically, this is done by starting with the current
interest rate on U.S. Treasury Inflation Protected Securities (TIPS). TIPS
carry virtually no risk and are inflation-protected, so their rate closely
approximates a real-risk rate. Treasury T-Bills have similarly low risk, but
are not inflation-protected. Simply subtract the TIIPS rate from the T-Bill
rate to obtain an estimate of the inflation premium. Use securities of the same
maturity (10-year securities are most often used).
DRP
= default risk premium
•A
default premium is the additional amount a borrower must pay to compensate the
lender for assuming default risk. A default premium is generally paid by all
companies or borrowers indirectly, through the rate at which they must repay
their obligation.
•Typically
the only borrower in the United States which would not pay a default premium
would be the U.S. government. However in tumultuous times, even the U.S.
Treasury has had to offer higher yields in order to borrow. The default premium
is paid by companies with lower grade bonds or by individuals with poor credit.
LP
= liquidity risk premium
•Liquidity
risk is the risk stemming from the lack of marketability of an investment that
cannot be bought or sold quickly enough to prevent or minimize a loss. With
liquidity risk, typically reflected in unusually wide bid-ask spreads or large
price movements, the rule of thumb is that the smaller the size of the security
or its issuer, the larger the liquidity risk. Drops in the value of stocks and
other securities in the aftermath of the 9/11 attacks and the 2007-2008 global
credit crisis motivated many investors to sell their holdings at any price,
causing widening bid-ask spreads and large price declines, which further
contributed to market illiquidity.
•Investors,
managers and creditors utilize liquidity measurement ratios when deciding the
level of liquidity risk within an organization. They often compare short-term
liabilities and liquid assets listed on the company’s financial statements. If
a business has too much liquidity risk, it must sell assets, bring in
additional revenue or find another method of shrinking the difference between
available cash and debt obligations.
•Financial
institutions are also scrutinized as to whether they can meet their debt
obligations without realizing great losses. The institutions face heavy
compliance issues and stress tests for remaining economically stable.
•Buying
a bond with a longer time to maturity increases the likelihood that interest
rates could rise over that period. The maturity risk premium is the extra yield
you will earn from buying a bond with a longer time to maturity.
•Maturity
risk premium can be viewed by comparing the same investment with different
maturities. Your bank may pay 4 percent on a one-year CD and 5 percent on a
5-year CD. You earn an extra 1 percent per year to tie your money up for the
longer maturity. The market interest rates for Treasury securities of different
maturities also indicate the maturity risk premium. At the time of publication,
the yield on a 20-year Treasury was 2.13 percent. The yield for a 30-year
government bond was 2.53 percent.
最后修改: 2018年08月14日 星期二 08:42